Opportunities And Risks Of An Interest-Only Mortgage: A Guide For Home Buyers

Buyer

May 08, 2018

Opportunities

1. Lower monthly payments

The main and obvious advantage of an interest-only mortgage is its low monthly payments. This benefits buyers who are looking to buy a relatively expensive property, since an interest only loan allows you to buy a pricier house than you would be able to afford with a standard fixed-rate mortgage. Lenders calculate the amount you can borrow based on your debt-to-income ratio, and if your monthly loan payments are low, the amount you can get for a loan goes up.

2. More control over where you put your money

Lower monthly payments on your mortgage give you the freedom to invest some of your money elsewhere since you’ll be freeing up more of your expendable cash. With an interest-only loan, the money that you don’t have to spend on large monthly mortgage payments can be used to pay other financial obligations.

Also, if you’re juggling a few goals on top of owning a home (such as putting up a business or going to graduate school), you can really benefit from the increased cash flow that is made possible by an interest-only loan.

3. Greater flexibility with payment schedules

An interest-only loan allows more flexibility in terms of balloon payments. Which is a great thing, since the best way to manage an interest-only loan is to make principal payments whenever possible. For example, if you get an unexpected bonus or raise, you can choose to apply the extra money towards the principal. This way, any differences in your standard of living won’t be affected. Doing this will also decrease the risk of your monthly payments shooting up to an unaffordable amount. In any case, you can easily go back to just paying the interest amount in the event of sudden medical expenses or temporary unemployment.

4. Less pressure on first-time home buyers

For first-time home buyers, an interest-only loan provides them more time to increase income before the interest-only term expires.

Since you can defer large payments into future years when you expect your income to improve, there is less pressure on paying off your mortgage for the first 5 to 10 years. Take advantage of this by shifting your focus towards growing your finances.

Risks

1. Being unprepared for higher payments

Compelling data shows that up to a third of borrowers with interest-only loans may not realize that the loan will convert. UBS writes that approximately 3 out of 10 people who take out interest-only loans have little understanding of the product, and are unaware that their repayments will jump by 30 to 60 percent at the end of the interest-only period. This can be very dangerous assuming that they cannot afford the higher payment when the “teaser rate” expires. If they decide to sell, they get nothing since they haven’t got any equity in the home.

However, even if you are aware of the terms of an interest-only loan, don’t make the mistake of being unprepared for when the loan converts to a traditional mortgage after the end of the interest-only term. Have a realistic foresight of what your income will be in a few years. Banking on unsure sources of income can be disastrous when higher payments on your loan begin. This means that you can’t solely rely on that promotion your boss keeps promising you, or on an investment that isn’t generating enough returns.

2. A rise in interest rates

Many homeowners will want to utilize refinancing as a way of lowering their monthly payments, but this will not be a good idea if interest rates rise. Some may even rely on refinancing to fund major purchases and get rid of debt, but a rise in interest rate will have a significant impact on monthly payments as well.

3. A decline in housing prices

What makes interest-only mortgages a high-risk choice is the possibility of housing prices going down. Homeowners who take this kind of mortgage may land a poor deal for the home if they plan to sell before the loan converts. When housing prices fall, some sellers are left with no choice but to default on the mortgage, which is likely to end up being worth more than the house.

Honesty is paramount to anyone who is interested in getting an interest-only mortgage. This means having an honest assessment of your capability to use the loan properly and as part of a strategy, and not just to take advantage of low monthly payments (without having a long term plan to afford it when the loan eventually converts).

If you do have a plan, be sure that you have every intention to follow through. Otherwise, you may end up with large monthly payments that you cannot afford. If your income is irregular like the majority of people who take interest-only loans, it is advisable to keep your monthly obligations low and make lump-sum payments when you have the extra cash.

With low monthly payments during the interest-only period, you’ll definitely be able to free up a substantial amount of expendable cash. The key is to make use of this money wisely, and to not spend it on things that won’t serve you well into the future. Instead, choose to invest the extra money in repayment vehicles that are proven to give superior returns, or use it to pay off any other debt you may have.

This way, you can expect a bigger return and then when the loan is due, and you won’t have to worry about not having enough money to pay it off.